If you are looking for an efficient way to profit from the stock market, contracts for difference (CFDs) offer you a number of advantages over stock ownership. They can be used with conventional strategies and will magnify your gains. This is primarily because of the gearing of your money that is available – typically you will only need to have 10% or less of the value that you are trading, and the rest of the money is ‘on margin’ – effectively borrowed. In addition, in countries where stamp duty is applicable to stock ownership, this will be saved trading CFDs as there is no transfer of ownership.
CFDs are Particularly Suited for Short-Term Trading
In particular contracts for difference are well suitable for short-term trading, and by this I mean trades held for periods of just a couple of minutes up to a few weeks. This is not only because they are margin products (which magnifies small share price movements) but also due to the stamp duty exemption in the UK and Ireland which allows for an immediate saving of 0.5% compared to when buying the underlying securities. This makes CFDs a very cost-effective way to trade shares especially considering that CFD brokers will only typically charge 0.1% each way meaning that a trader could pay a total of 0.2% to open and close the trade.
Let’s take the case of Marks & Spencer stock when this was trading at £3.549. Buying 5,000 CFDs of Marks & Spencer at this level would have been equivalent to a market exposure of £17,745. If Marks & Spencer shares rallied by 40p the total holding would now have been worth £19,745 and this could have been closed out for a gain (before costs) of £2,000. Assuming a commission charge of 0.1% each way, the trader would have had to pay £37.49 in brokerage commissions in all (excluding financing costs). Compare that to a conventional share purchase which would have required the investor to put up £17,848 (i.e. £17,745 + £88.73 stamp duty + £15 dealing commission) just to enter the trade (and that without the exit commission).
‘As a short-term trader I look to enter a stock and take a small profit before I sell it and I might do that with the same stock several times a day.’ ‘I prefer high volume and plenty of liquidity. I like to know that when I buy a share I can sell it just as easily. I also look for positive momentum and positive announcements associated with the company, which might drive the price up.’ ‘In practice 70% of my time is spent reading and researching shares with the most critical rule being to stay disciplined’ – Angelo Carapella, short-term trader with 20 years’ experience in the financial markets.
If you are looking to trade short-term (as opposed to long-term), then it makes sense to focus on just a few markets the movements of which you fully understand. With few changes you can develop short term trading strategies for CFDs based on stock trading strategies. These would include trading with a trend as soon as you can identify it, and allowing the trend to progress until it showed signs of slowing. With the leverage from CFDs, it is quite possible to double your money using this technique, which would be exceptional if you chose to use shares alone.
The one difference that you may hear mentioned between using CFDs or shares for your trading is the daily interest charged to hold a CFD position, if you keep it overnight or longer. The interest is usually charged at a published rate plus a couple of points, and if you are interested in short term trading, it will not amount to much over the holding period. You can go short with CFDs as easily as long, and if you do you will receive interest. Again, not a significant amount, but a benefit.
Unlike some other derivatives, such as futures and options, which also give you increased leverage, contracts for difference have the advantage that they do not have an expiration date. If you are holding a winning position, you can ‘let your winners run’ without fear that you will be forced to close out. While you are winning, your account gets credited every day by ‘marking to market’, a process of giving you the increase in value in your position.
Use CFDs Responsibly
Of course, with large leverage comes responsibility to make sure that you do not suffer losses that you cannot bear. Contracts for difference can cause you to get a ‘margin call’ if, when they are marked to market, the value of your holding has fallen. This means that you may have to send your CFD dealer more money just to maintain your position, otherwise he may close it at a loss for you. It helps if you only plan to trade with half of the money in your account, as this leaves the remainder as a buffer against getting such a call.
Short term trading, catching profits in days or weeks, has become a popular way of speculating for profit, and by studying technical analysis you can identify which stocks or securities are ready to move. Using CFDs is convenient and will help to maximize your profits but you need to be disciplined and use limit and stop orders effectively.